Getting your hands on your pension fund from April 2015 sounds like a great idea, but if you don’t pay attention to your Income Tax position, HMRC could end up with more of your pension fund than you!
Your Marginal Rate Of Income Tax Really Could Be 60%
Before You Draw Your Pension Fund, Check Your Income Tax Position First
There’s been much talk about people blowing their pension funds on Lamborghinis, or taking the money and reinvesting it in buy to let properties. But before you break out the champagne to celebrate your windfall, it’s worth checking the Income Tax implications of your actions.
Providing you’ve reached the grand old age of 55, from April 2015, you’ll be able to access your whole pension fund. It’s pretty well known the first 25% of your pension fund is tax free. Technically, your ‘tax free cash’ is known as the ‘pension commencement lump sum’. Whatever it’s called, you won’t pay any Income Tax on the money you draw up to this level. But draw a penny more than 25%, and it could end up being a costly mistake that you might be able to avoid.
Any money you draw that’s in excess of 25% of your pension fund will be taxed as income. Once you’ve had your tax free cash, the money you extract from your pension fund is added to all your other sources of income. That includes any earnings from work, whether you’re employed or self-employed, and any savings and investment income too. It means you’ll pay Income Tax on your pension fund, at your ‘marginal’ rate. Here are the rates of Income Tax for 2014/15.
Income Tax Bands - 2014/2015
Each of these bands is effectively a margin. The first margin being £10,000 on which no Income Tax is paid. The next margin is £31,865, on which Income Tax at 20% is paid. And so on. But there’s a sting in the tail.
Your Effective Rate Of Income Tax Could Be 60%
If you look at the table above, you won’t see an explicit rate of Income Tax of 60%. But once your income reaches £100,000, in addition to paying 40% Income Tax on that margin, your personal allowance starts to shrink. It disappears at the rate of £1 for every £2 of income. By the time your income reaches £120,000, you have no personal allowance left.
In the current tax year, your personal allowance is £10,000. But as you lose it in the £100,000 to £120,000 band, it means your effective rate of Income Tax is 60% in that margin.
If you blindly draw your pension fund without considering the tax consequences, just because you can, you might be in for a shock when more than half of it goes to HMRC. It’s clearly not what you had in mind when you put aside all those pension contributions for all those years.
You Need To Plan Your Pension Fund Withdrawals Carefully
To ensure you limit your Income Tax liability whilst you maximise the amount you extract from your pension fund, you need to examine your whole tax position. If you’re still working, you may find it’s more effective to wait until your income has fallen to a lower Income Tax band. If you're desperate for money now, maybe limit the amount you withdraw to the minimum you actually need. That way, you’ll reduce the amount of Income Tax you’ll pay at your highest rate.
The Chancellor has been very clever with his Budget announcement. It’s a classic case of ‘selling the sizzle and not the steak’. It’s expected that tens of thousands of people will be so keen on getting their hands on their pension funds, they won’t necessarily appreciate all of the unintended Income Tax consequences. The Treasury has calculated this move will raise billions. For it’s not just the fact you could pay a potential rate of Income Tax of 60% on part of your pension fund withdrawal, in taking your money out of a tax privileged area, you’re potentially exposing it to further taxes once you’ve reinvested it. That includes even more Income Tax, Capital Gains Tax and Inheritance Tax, all of which are significantly lower or simply not charged within pension funds.
There’s a lot of useful information on Income Tax and other taxes on HMRC’s website. But if you’re not entirely sure of your Income Tax position, it’s well worth a consultation with either your adviser, or your accountant, to ensure you don’t blow years of hard work building your pension fund on an unnecessary amount of Income Tax.
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Over time, charges can wipe out a huge part of your fund. We like AJ Bell because there are no set-up costs. If you hold passive funds, which is our preference, or shares, investment trusts, EFTs, gilts or bonds, you pay one small fixed fee no matter how large your fund. And when you come to draw your benefits either as occasional drawdown or UFPLS payments, there's a small charge for the whole year no matter how many times you access your money (many SIPP and SSAS providers charge more than this for each payment). However, you should always compare charges in detail, because AJ Bell could be more expensive than other providers, depending on the type of stockmarket assets you hold.
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